The investor flight out of fixed income securities that occurred both before and after the June Federal Reserve (Fed) meeting had a significant impact on the municipal bond market. Fueled by what we saw as a misguided fear of a Fed rate hike and a muddled message from Fed officials, including Fed Chairman Ben Bernanke, the municipal bond sector saw abysmal outflows due to some forced selling amid a significant flight by retail investors.

We are very confident that the municipal bond market remains fundamentally sound and, we believe, high-yield munis continue to offer value, especially for investors seeking the benefits of tax-free income.

Responding to panic

Over the four weeks ending June 19, municipal bond mutual funds had net outflows of more than $9 billion, according to Investment Company Institute (ICI) data, with more than one-third of that total occurring the week ending June 19. Although outflows across the fixed income market challenged fund managers, the municipal bond market – and especially the high-yield municipal bond market – can become highly illiquid, which means that a wave of forced selling has the potential to have an enormous impact on prices.

We wrote in a December 2012 Portfolio Perspective (High Yield Munis: Is the best offense a strong defense?) that we believed the bond market had entered bubble territory and that while the market could remain at or near its then-current levels, a reversal was inevitable. As a result, we had moved the Fund into a more defensive stance, purchasing higher coupon bonds priced to shorter call dates. This move was in line with our overall strategy about the amount of risk we are comfortable with and the importance of credit selection in a high-yield municipal bond fund.

To implement a more barbell-style approach, we were purchasing tax-exempt floating rate securities at a time when there was not significant market demand. That environment, however, has changed dramatically in recent weeks as the liquidity of these securities has become increasingly valuable to the market. As a result, we were able to sell these securities at more attractive prices to meet our liquidity needs while also maintaining our core portfolio structure.

The Fund does not hold large amounts of what we view to be especially volatile credits, particularly those related to prepaid gas and tobacco. Relative to the Fund’s index, we have also been underweight in categories such as industrial development revenue bonds, which have performed well, but which we believe posed an unacceptably high risk. Finally, we believe the Fund has benefitted from a lack of leverage.

The Fund’s core portfolio strategy remains unchanged. We are currently looking to take advantage of valuation opportunities that the current environment has created in fixed rate bonds with lower prices and higher-yielding credits. We believe the market is now extremely oversold and, as a result, we have turned very bullish on the space.

As we have previously said, our focus is on positioning the Fund for the longer run and recent events have only further supported our view. The interest rate picture has become increasingly clouded by the public comments of Fed officials. Although we do not believe a rate increase is imminent, the June market turmoil was clear evidence that the market has a heightened sensitivity to the risks that are posed by a rising-rate environment.

Looking ahead

Although the recent focus has been on interest rates, it is important to note that market fundamentals remain strong. Although we have seen another round of high-profile municipal budget struggles – as is unfolding in Detroit – the issues continue to be isolated, based on local management problems and well-known in advance within the municipal bond market. Certainly, the problems in Detroit have been well documented for decades. Fears of a wave of municipal defaults remain unwarranted, with first-quarter state and local tax revenues increasing 6.8% from the previous year, according to Census Bureau data. The increase marks the 14th consecutive quarter of positive year-over-year tax revenue growth.

Regarding the muni market, by late June there were signs that investors were regaining their appetite for tax-free debt, particularly higher-yielding debt. The state of Illinois, which has the lowest credit rating of the 50 states, had $9 billion in bids for $1.3 billion in state general obligation bonds, according to Bloomberg.

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current and are subject to change due to market conditions or other factors.

Consider all factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. The lower-rated securities in which the Fund may invest may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund may include a significant portion of its investments that will pay interest that is taxable under the Alternative Minimum Tax (AMT). These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for any of the Waddell & Reed Advisors funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

The products and services described in this website are for U.S. residents only. The products and services offered within this site are available through our financial advisors. Waddell & Reed financial advisors may only conduct business with residents of the states for which they are properly registered. Some products and services mentioned may not be available in all states or to all clients. Brokerage, investment and financial advisory services are made available through Waddell & Reed, Inc.

Certain Waddell & Reed offices are located in banks, credit unions and other financial institutions. Investment products offered by Waddell & Reed, Inc. on the premises of financial institutions are not insured by the FDIC, are not deposits or other obligations of the financial institution and are not guaranteed by the financial institution, and are subject to investment risks, including possible loss of the principal invested.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or click here. Please read the prospectus or summary prospectus carefully before investing.

Do you want 'Individual Investors' to be the first page you see when you visit Waddell.com?
This will NOT affect your browser's home page and can be reset at any time.